Cost Theory (MBA notes, case studies)

Cost theory is a concept in economics in which costs such as fixed costs, variable costs, total costs, average costs, and marginal costs are analyzed to see how they influence a company’s production volume and its profitability.

Elements of costs are as follows:

• Material Cost: Cost of material and commodities
  Direct Materials: Direct materials are those which an be identified with individual cost centers and which becomes an integral part of finished products. Example: timber used for furniture, bricks and tiles for building
  Indirect Materials: Cannot be identified with indicidual cost centers, not integral part of the finished product.
  Example: Lubricants, cleaning materials, etc.
• Labour Cost: Salaries, wages, etc.
  Direct Labour cost: Costs for those who are directly engaged in manufacturing process
  Indirect Labour cost: Costs for those who are NOT directly engaged in manufacturing process
• Expenses: Cost of services provided to the organisationDirect Expenses: Can be identified with a particular job or individual cost center. Example: payment for designing, hiring a machine for a special job
  Indirect Expenses: Not for a particular job. Example: Rent of building, telephone bill
• Prime Cost: Aggregate of all direct costs
• Overheads: Aggregate of all indirect costs – Manufacturing overheads, office and administration overheads, selling & distribution overheads.

Various Costs

• Costs for decision-making
• Explicit and implicit costs
• Historical and current costs
• Sunk and incremental costs

EXPLICIT COSTS – expenses or out-of-pocket costs (rent, raw materials, fuel, wages); normally recorded in a firm’s accounts.

However, the economic cost of using a resource is its opportunity cost, which is the cost of forgoing the next most profitable use of the resource, or the benefit that could be obtained from the next-best use
involves both explicit and implicit costs.

Student considering undertaking an MBA; the relevant costs can be classified as follows:

a) Explicit Costs

fees, books, accommodation, food, transportation, recreation and entertainment etc. Not all of these may be directly related to doing an MBA, incidental costs. Money still has to made available to pay these costs.

b) Implicit Costs

noncash costs, like the salary that could have been earned, leisure time foregone (if work required on the MBA exceeds time of salaried work), and interest foregone on assets which have to be used to pay MBA expenses.

Opportunity costs would include elements of both, but are not simply the sum of the two; for example, accommodation is not an opportunity cost if the student would be in the same accommodation whether they were doing the MBA or not. Opportunity costs should be used for decision-making.

HISTORICAL AND CURRENT COSTS

(a) Historical Costs

These represent actual cash outlay and this is what accountants record and measure. This means measuring costs in historical terms, at the time they were incurred. Although this is relevant for tax purposes it may not reflect the current costs.

(b) Current Costs

These refer to the amount that would be paid for an item under present market conditions, often the replacement cost

SUNK AND INCREMENTAL COSTS

(a) Sunk Costs

These are costs that do not vary according to different decisions. An example was given earlier in the case of the MBA student’s accommodation; the accommodation cost was the same whether or not the student did the MBA. Often these costs refer to outlays that have already occurred at the time of decision-making.

(b) Incremental Costs

These refer to changes in costs caused by a particular decision. if the student would have to pay £6,000 for yearly accommodation doing a salaried job and £9,000 for accommodation to do the MBA, the incremental cost associated with the decision to do the MBA is £3,000.

SHORT RUN

a) CLASSIFICATION OF COSTS

FIXED COSTS – costs of using fixed factors: rent, insurance, interest, depreciation. Do not vary with output.

VARIABLE COSTS – costs of using variable factors: raw materials, labour, fuel. Vary directly with output.

b) UNIT COST

PURPOSE

• Comparison with price to determine profit
• Efficiency

c) TYPES OF UNIT COST

• Average fixed cost (AFC) = FC/Q
• Average variable cost (AVC) = VC/Q
• Average total cost (ATC) = TC/Q = AFC + AVC
• Marginal cost (MC) = ΔC/ ΔQ

d) RELATIONSHIPS WITH OUTPUT

• AFC – falls as output rises because FC becomes spread over a larger output
• MC – falls at start as output rises because of increasing returns and then starts to rise because of diminishing returns
• AVC – same as above
• ATC – same as above because it is the sum of AFC and AVC
• Note: MC intersects both AVC and ATC at their minimum points.

f) EFFICIENCY – where ATC is at a minimum – compromise between spreading FC and getting diminishing returns.

LONG RUN

a) NATURE

• All costs are variable – no fixed factors
• Unit costs affected by EOS and DOS:
  Cost advantages and disadvantages of being bigger
• Internal and external
• EOS = ASPECTS OF INCREASING SIZE OR SCALE THAT LEAD TO FALLING LR UNIT COSTS
• DOS = ASPECTS OF INCREASING SIZE OR SCALE THAT LEAD TO RISING LR UNIT COSTS

b) ECONOMIES OF SCALE

• Technical – increased specialisation and indivisibilities
• Managerial – larger firms can employ more specialised managers
• Marketing – buying in bulk, discounts
• Financial – easier and cheaper to borrow or raise funds

c) DISECONOMIES OF SCALE

• Technical – lower morale, problems of interdependence of operations
• Managerial – problems of communications, leading to lack of control and coordination

d) RETURNS TO SCALE

• IRTS: EOS > DOS: falling unit costs in LR: mass manufacturing, utilities
• CRTS: EOS = DOS: constant unit costs in LR: general retailing
• DRTS: EOS < DOS: rising unit costs in LR: specialized retailing/services

Some industries combine all 3 shapes at different ranges of output

A PROBLEM-SOLVING APPROACH

Five useful EQUATIONS:

• C = a + bQ, a = FC, b = AVC = MC
• R = PQ with P constant
• PROFIT = R – C
• BEO = FC/(P – AVC)
• PCPU = P – AVC

You need to solve in CORRECT SEQUENCE.

Cost Sheet

A Cost Sheet is a statement / report which provides a detailed overview of the cost incurred on various components during the process of production. The cost sheet is a periodical statement that may be prepared monthly, quarterly, yearly etc.

A cost sheet lists the following elements:

• Prime Cost: This includes all the direct material costs (raw material costs) and direct labour costs
• Works Cost (Factory Cost): Add to Prime Cost all the Factory Overheads, including indirect material and indirect labour costs.
• Cost of Production: Add Office or Administrative Overheads to Works Cost
• Total Cost: Add Selling and Distribution Costs to Cost of Production and this will give the Total Cost / cost of Goods Sold (COGs)

How does it help?

Here’s why a cost sheet is prepared:

• A cost sheet reveals the margin earned on a product or job, and could form the basis for pricing similar products in future.
• It can also form the basis for a variety of cost control measures.
• It helps in classification and analysis of the various cost components associated with a product or service.
• It also helps the company to formulate a suitable production policy.

Classification of Cost Elements

The following categories of costs are usually listed on the report:

• Direct Material Cost
• Direct Wages
• Direct Expenses
• Production Overheads
• Research and Development Cost
• Administration Overheads
• Selling and Distribution Overheads

The various cost elements are usually classified on functional basis. But it could be classified on other factors as well, depending on the requirements of the firm.

Method of Preparation of Cost Sheet

Step I = Prime Cost = Direct Material + Direct Labour + Direct Expenses.

Step II = Works Cost = Prime Cost + Factory/Indirect Expenses.

Step III = Cost of Production = Works Cost + Office and Administration Expenses.

Step IV = Total Cost = Cost of Production + Selling and Distribution Expenses. Profit = Sales – Total Cost.

Cost Sheet Examples

Cost Sheet of MRF Automobile Tyres for the year 2018

Prime Cost: The direct material and labour costs.

• Opening Stock of Raw Materials
• Raw Materials purchased during the year (most of the expenditure happens on buying raw materials which s used for making tyres).
• Raw Materials in Transit
• Less: Closing Stock of Raw Materials
• Productive Wages
• Less: Material destroyed

This will give the Total Prime Cost.

Works Cost (Factory Cost): The indirect material and indirect labour costs.

Add: Factory Overheads

• Indirect Material:
• Indirect Labour (Wages)
• Power and Fuel
• Factory Lighting and Supervision

Factory Insurance

• Depreciation – Plant and equipment (Major expense here is the depreciation of the plant and the equipment/machinery)
• Miscellaneous

Total Factory Expenses

Add: Opening Stock of Work-in Progress (Cost)
Less: Closing Stock of Work-in Progress (Cost)

Total Works Cost

Cost of Production: This includes office and administrative costs.

Add: Office or Administrative Overheads

• Office Salaries (Major expense is the salaries of the office staff)
• Management Expenses / Travel
• Office Insurance
• Bank charges
• Other Office Expenses

Total Cost of Production

Add: Opening Finished Goods (Cost)
Less: Closing Finished Goods (Cost)

Cost of Production of Goods Sold

Total Cost: This includes all the selling and distribution costs related to selling of the finished goods.

Add: Selling and Distribution Costs

• Warehouse & Showroom Rent
• Salesmen Salaries & Commissions
• Advertisements
• Freight and Forwarding
• Insurance
• Depreciation Furniture and fixtures & Computers)
• Product warranty claims
• Miscellaneous

Total Cost / Cost of Goods Sold (COGS)
Profit / Loss (difference of Sales and COGS)

Questions and Case Studies

Management (MBA) questions and case studies on Non-monetary costs.

Q) Complete the hypothetical table below and explain in brief, the behaviour of each type of cost.

Total Fixed Cost, Total Variable Cost, Total Cost, Average Fixed Cost, Average Variable Cost, Average Total Cost, Marginal Cost

Q) Summer vacations for the kids are round the corner. This time around, you have decided to surprise the kids with the Big Summer Holiday that you and your better half had been contemplating since long. Choosing between a 7-day European dreams or The best of U.S or Amazing Australia or the umpteen options flashing on various travel sites, is indeed a complicated decision; especially in the backdrop of a budget constraint. Quite obviously, while the flashy packages offer the ‘oh-so’irresistable’ deals, these prices are not just the only costs that the customer has to incur. The real cost of the service to the customer is an amalgamation of many inter-related monetary and non-monetary costs.
Discuss the various search, purchase and post-purchase costs that you will have to incur in the purchase of the holiday package.